Understanding the true value of a business is crucial to making informed decisions and maximizing returns. Accurately determining a company’s fair market value can provide valuable insights into its current financial health, potential growth opportunities, and areas for improvement.
What is valuation in business? What business valuation methods and approaches exist? And how to calculate business valuation? Find out in this article.
What is a business valuation?
In short, business valuation is a process of determining the economic value of the company, giving owners an objective estimate of the business worth.
During the valuation process, all areas of the business are analyzed, and all business assets are assessed. The valuation of a business embraces tangible assets and intangible assets, as well as the analysis of the company’s management, its future earnings prospects, and current capital structure.
Business valuation is performed for various reasons, including a sale, taxation, establishing partner ownership, and divorce proceedings or as a part of a divestiture strategy. However, company valuation can also help identify ways to improve operations when performed regularly.
Note: Learn how to perform M&A financial modeling in our dedicated article.
Why is a valuation of a business important?
Business valuation allows owners to define the true value of a business, which is beneficial in many regards. Not only does it help to determine the current market value and position of the company, but it also highlights the areas that need attention and offers new opportunities for growth.
Business valuation is also often used for tax reporting. This is because the Internal Revenue Service (IRS) requires businesses to be valued based on their fair market value.
In general, calculating business valuation helps to put a business owner in a strong position when:
- Selling a business
- Attracting investors
- Seeking a merger or acquisition of another business
- Planning for business expansion
- Adding shareholders
- Establishing the percentage of partner ownership
- Considering an exit strategy
- Planning for tax reporting
Business valuation approaches
There are 3 main approaches for business valuation: market-based, income-based, and asset-based. Every approach offers separate business valuation methods.
Let’s first see what each approach implies.
Market-based approach
The market-based approach is a common way to define the current value of a business.
It implies comparison. Simply put, this approach compares a company to similar businesses in the same industry. These similar businesses are usually called “comps”. To find a market value of a company, consider comps that have been recently sold and compare their price to your business.
For example, if a comparable company was sold for $6 billion, the present value of your company is probably similar.
The market-based approach provides a relative value for a company, and when combined with other approaches, it can give a more accurate picture of the business value.
The market based-approach usually involves the following business valuation models:
- Public company comparable
- Precedent transaction analysis
Income-based approach
The income-based approach is often used for the business valuation of operating companies.
It implies measuring the current business value of projected future cash flows generated by the particular business. In other words, you define the value of a business by estimating the expected net income through a certain period of time and recalculating the current cash flow.
This approach is considered to provide an intrinsic value and is usually performed when a company is seeking a merger or acquisition of another company.
The income-based approach usually involvesimplies these business valuation methods:
- Discounted cash flow (DCF) method
- Capitalization of earnings
Asset-based approach
The asset-based approach is widely used for a business valuation of companies that have investments.
As the name suggests, according to the asset-based method, the present value of a company is the difference between a fair market value (FMV) of the net assets of a company and its liabilities.
This approach is especially useful when valuing real estate, such as new construction or commercial property.
An asset-based approach to business valuation usually implies the following methods:
- Book value
- Liquidation value
6 common business valuation methods
Now, let’s see how each business valuation method is calculated and what it’s about.
- Market-based approach
1. Public company comparable
2. Precedent transaction analysis - Income-based approach
3. Discounted cash flow method
4. Capitalization of earnings - Asset-based approach
5. Book value
6. Liquidation value
1. Public company comparable
The public company comparable method presupposes evaluating a particular company based on the market value of its competitors.
The comparison is possible only with public companies that have all their metrics publicly available. Often, it might be difficult to reach direct compatibility, since the majority of public companies would be larger.
How to calculate?
There’s no specific business valuation formula for this method since the resultant value is relative. However, these are the recommended steps to perform a business valuation with a public company comparable method:
- Choose the appropriate list of comparable public companies
- Define the metrics and multiplies you want to use
- Calculate the metrics and multiples for all the comparables from the list
- Apply the 25th or 75th percentile multiples median from the comparables to your company to get its implied enterprise and equity value
2. Precedent transaction analysis
The precedent transaction analysis presupposes defining the value of your business based on the comparison of the recent M&A transactions in similar industries.
This method is commonly used when trying to value a business as a part of a merger or acquisition deal and is usually performed by private equity, investment banking, or corporate development analysts.
How to calculate?
To define the value of your business with the help of precedent transaction analysis, follow these steps:
- Explore the relevant transactions that took place recently
- Analyze the most appropriate deals
- Define the range of valuation multiples
- Apply the multiples to your business
- Note the results
3. Discounted cash flow method
The discounted cash flow analysis is often considered a golden standard of business valuations.
According to the discounted cash flow analysis, the company’s present value is based on the projected future cash flows over a certain period (typically 5 years).
This model is built on the theory that the value of a business is equal to the present value of its future profits plus the present value of the residual cash flows.
How to calculate?
The basic formula for the calculation of the business valuation via the discounted cash flow model is the following:
DCF = CFt / (1 +r)t
Where,
- “CFt” stands for the cash flow for period “t”
- “r” stands for the discount rate that has given the riskiness of cash flows
- “t” stands for the life of the valued asset
However, the DCF calculation is a much more difficult process that requires professional expertise. Often, extra software tools are used, such as a business valuation calculator
4. Capitalization of earnings
The capitalization of earnings method calculates the business value based on its cash flow, return on investment (ROI), and expected value.
The most important part of this model is the assumption that your profits, growth, and finances will be stable for a long period of time. Thus, this model is best suited for businesses expecting stable cash flows for years.
How to calculate?
The capitalization of earnings method is usually calculated using the formula:
Value of a business = Net Operating Income / Capitalization Rate
5. Book value
The book value method of valuation is also often called the going concern method. It’s used to value a company that plans to continue its operations after the valuation process.
The book value method reviews the company’s balance sheet, lists its total net asset value, and subtracts its liabilities.
How to calculate?
There’s no difficult formula for business valuation via the book value method. The book value of the company is calculated by defining the company’s total assets and then subtracting its total liabilities.
6. Liquidation value
The liquidation method is considered the most straightforward. It’s used to value the businesses that are looking to be sold.
This method presents the value of a company if all of its assets are liquidated and liabilities are immediately paid off. Notably, with this method, the business value is usually lower than with other methods.
How to calculate?
To calculate the liquidation value of the business, simply remove the value of all assets and liabilities from the financial report.
4 main factors to know when performing business valuation
This is what you, as a business owner, should be aware of when considering business valuation services:
- Tangible assets. These include all physical assets, such as property, inventory, and machinery. Tangible assets are the easiest to calculate.
- Intangible assets. These include trademarks, patents, brand names, etc. Intangible assets are important to calculate correctly, as they add significant value to the business’s fair market value.
- Liabilities. These are all the business’s debts.
- Financial statements. These provide information about the business’s profits, revenues, expenses, and liabilities.
Summing up
The business valuation is equally important for businesses that are considering a sale and those that plan to continue operations.
Business valuation provides business owners with an objective estimate of their business worth.
There are 3 main approaches to business valuation: market-based, income-based, and asset-based. Each approach implies a few methods.
The most common business valuation methods are public company comparable, precedent transaction analysis, discounted cash flow method, capitalization of earnings, book value, and liquidation value.
